Why We Don't Rebalance
For investors, the $1 million question is, "Why don't all of us rebalance?" according to Jason Hsu, chief investment officer at Newport each, California-based Research Affiliates.
In Research Affiliates' July newsletter Hsu says research shows the long-term benefit of rebalancing, yet anecdotal evidence suggests that most investors don't rebalance their portfolios-that is, buy assets that have become cheap and sell assets that have become expensive. In fact, many investors do the exact opposite.
The reason it's so hard for investors to rebalance, says Hsu, is less about "behavioral mistakes" and more about "the fact that 'rational' individuals care more about other things than simply maximizing investment returns. Perfectly rational individuals exhibit changing risk aversion that makes it hard for them to rebalance into high-return assets that have had steep price declines,"he says. "An unwillingness to buy low and sell high is not characteristic of just retail investors unaware of the finance literature and market history, but also sophisticated institutional investors advised by investment consultants and academics who are also prone to the same behavior."
Hsu says financial research shows that asset classes exhibit long-horizon price mean-reversion. So when an asset class falls in price, resulting in a more attractive valuation level relative to history, it's more likely to experience high subsequent returns. For example, when the S&P Index falls in price, its dividend yield increases; empirically the subsequent five-year return on the S&P tends to be significantly above average.
Similarly, when corporate bond prices fall as credit spreads blow out, the forward return on corporate bonds increases, says Hsu. Price mean reversion in asset returns suggests that a disciplined rebalancing approach in asset allocation that responds to changing valuation levels would improve portfolio returns in the long run.So, if "buy low and sell high" works so well, why don't we investors rebalance? Hsu says research suggests that investors become more risk averse and unwilling to add risk to their portfolios despite lower prices when their portfolio wealth declines. Investors tend to become more risk seeking and, therefore, more willing to speculated even when their portfolio wealth increases.
In bear markets when personal income and wealth is declining, any further loss in portfolio value could reduce the household's quality of life and retirement planning, he says. Investors become more risk averse and unlikely to want to take on more investment risk, even when assets are attractively priced, he adds.
If the $1 million question is "Why don't investors rebalance?" Hsu adds, then the $5 million question is "Should you rebalance?' Statistically, he says you're likely to outperform in the long run if you rebalance in response to major price movements. However, when you buy risky assets during economic distress, Hsu says, there's a strong chance your portfolio may post a greater decline than if you didn't rebalance, so things won't look so rosy in the short run. That's why rebalancing takes such discipline. In spite of the benefits of rebalancing, our changing risk aversion make us poor stewards for managing long-term returns.
Wednesday, July 25, 2012
Monday, July 16, 2012
5 bad investment ideas-and how to avoid them
Do your best to side step these financial pitfalls:
1. Driving while looking in the rear view mirror.
What's one of the top methods of choosing your 401k investments? It's simple. You look at the different funds and you select the ones that have increased the most in the last year. That small cap fund looked great when it was up 27% in 2010. The problem is that once you piled your retirement savings into it, it was down 8% in 2011 when the broader market was flat.
In fact, your tendency should be to purchase asset classes that have gone down and sell those that have increased in value. Rebalancing every year can give you superior returns.
2. Ignoring investment costs.
Most investors don't have a clue about investment costs, yet it is the best predictor for future investment performance. Think of expenses as a moving walkway in the airport, except in this case you're the little kid running down the walkway going against you. The higher your investment fees, the faster that walkway races against you in your journey to financial independence.
Investment cost for mutual funds can be easily found on morningstar.com or from the fund company itself. More insidious are the expenses and tax impact of the fund buying and selling a big portion of its portfolio each year. Look at the fund turnover ratio to keep these costs down.
3. Letting investment inertia take over.
Inertia can keep you overly static or kinetic in your investment approach. Sure signs of an ossified portfolio are having three 401k plans in place from current and former employers. Letting your investments ride for two years or more without a thought means that you are giving up one of the most valuable investment strategies: regular rebalancing.
On the other hand, hyper focus on your portfolio performance can transform you into a twitchy smart phone trader. Twitchy rarely wins the investment race.
4. Letting the tax tail wag the investment dog.
Income taxes are on the mind of most of us in April, but there are times when too much focus on taxes can drive poor investment decision. An example of this is when to exercise stock options.
From a tax perspective, it makes a lot of sense to exercise options and hold stock long enough to qualify for long-term capital gains. Paying 15 % tax on your profit instead of 25% or worse sounds like a no brainer.
But, if your stock loses share value, you could end up owing taxes on profits you never even receive. The primary issue to consider should be the wisdom of a concentrated investment in one company, rather than the tax impacts.
Many investors purchase variable annuities and cash value life insurance policies for their purported tax benefits. Unfortunately, these investments often have annual expenses that exceed 2 %. That can wipe out any tax benefits, which could have been oversold in the first place.
5. Equating complexity to a desirable investment.
As we build up our net worth, there's a natural movement toward more "sophisticated" investments. This could take the form of a hedge fund, private Real Estate Investment Trusts, limited partnerships, and private equity funds. As a whole, these investments have a better track record of making money for the managers than the investors.
Many of these funds have fees of 2% annually plus 20% of investor profit. You need to hire an outstanding fund manager to overcome those fees. The odds are not in your favor.
Happy investing!
Randy Moore, CFP(r), CRC(r)
1. Driving while looking in the rear view mirror.
What's one of the top methods of choosing your 401k investments? It's simple. You look at the different funds and you select the ones that have increased the most in the last year. That small cap fund looked great when it was up 27% in 2010. The problem is that once you piled your retirement savings into it, it was down 8% in 2011 when the broader market was flat.
In fact, your tendency should be to purchase asset classes that have gone down and sell those that have increased in value. Rebalancing every year can give you superior returns.
2. Ignoring investment costs.
Most investors don't have a clue about investment costs, yet it is the best predictor for future investment performance. Think of expenses as a moving walkway in the airport, except in this case you're the little kid running down the walkway going against you. The higher your investment fees, the faster that walkway races against you in your journey to financial independence.
Investment cost for mutual funds can be easily found on morningstar.com or from the fund company itself. More insidious are the expenses and tax impact of the fund buying and selling a big portion of its portfolio each year. Look at the fund turnover ratio to keep these costs down.
3. Letting investment inertia take over.
Inertia can keep you overly static or kinetic in your investment approach. Sure signs of an ossified portfolio are having three 401k plans in place from current and former employers. Letting your investments ride for two years or more without a thought means that you are giving up one of the most valuable investment strategies: regular rebalancing.
On the other hand, hyper focus on your portfolio performance can transform you into a twitchy smart phone trader. Twitchy rarely wins the investment race.
4. Letting the tax tail wag the investment dog.
Income taxes are on the mind of most of us in April, but there are times when too much focus on taxes can drive poor investment decision. An example of this is when to exercise stock options.
From a tax perspective, it makes a lot of sense to exercise options and hold stock long enough to qualify for long-term capital gains. Paying 15 % tax on your profit instead of 25% or worse sounds like a no brainer.
But, if your stock loses share value, you could end up owing taxes on profits you never even receive. The primary issue to consider should be the wisdom of a concentrated investment in one company, rather than the tax impacts.
Many investors purchase variable annuities and cash value life insurance policies for their purported tax benefits. Unfortunately, these investments often have annual expenses that exceed 2 %. That can wipe out any tax benefits, which could have been oversold in the first place.
5. Equating complexity to a desirable investment.
As we build up our net worth, there's a natural movement toward more "sophisticated" investments. This could take the form of a hedge fund, private Real Estate Investment Trusts, limited partnerships, and private equity funds. As a whole, these investments have a better track record of making money for the managers than the investors.
Many of these funds have fees of 2% annually plus 20% of investor profit. You need to hire an outstanding fund manager to overcome those fees. The odds are not in your favor.
Happy investing!
Randy Moore, CFP(r), CRC(r)
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